Should McDonald's Be Worried About Wendy's?

Wendy's has outperformed its peers McDonald's and Burger King Worldwide by wide margins over the past year in regards to stock appreciation. Over this time frame, Wendy's stock has appreciated 81% while McDonald's and Burger King have seen stock appreciations of 8% and 30%, respectively.

The success of Wendy's has had a lot to do with its reimaging initiative and menu innovations. Burger King has also succeeded in the innovation area, whereas McDonald's has failed. But this doesn't necessarily mean that Wendy's and Burger King are likely to be better investment options than McDonald's over the long haul. We'll take a look. And while we're at it, we'll expose a strategic approach that Wendy's uses to increase sales.

The Wendy's turnaroundAfter founder Dave Thomas passed away in 2002, Wendy's lost its way and suffered an identity crisis. But it eventually came up with a strategy that proved to be highly successful. This strategy is easy to understand, and it's a common practice in business; you just don't see it used often in quick-service restaurants.

Wendy's decided to start offering a broad value menu. By offering more menu items, it was likely that Wendy's could drive more foot traffic. But that wasn't the key. The broad value menu was only used to get more people through the doors. Then Wendy's would use the up-sell approach by offering premium menu items. Once customers are through the doors and looking at the menu -- thanks to promoting value-menu items -- it's likely that some of these customers will notice the premium menu items and give them a go. Wendy's still uses this approach today, and until it fails to be effective, it will continue to use this approach.

The modernization of many restaurant locations has also helped drive the top line for Wendy's, but the real driver last year was the innovative $5 Pretzel Bacon Cheeseburger. This promotion ended in November 2013, as it was difficult to make in the kitchen and required premium ingredients. It was also a limited-time offering, which has been a hot trend in the quick-service restaurant space.

The limited-time offering approach has been effective for one simple reason: People want what they can't have. If a menu item is only available for a limited time, then people want to try it before it's not available anymore. Also consider that most people are followers (not a bad thing), which means that if everyone is talking about a new limited-time offer menu item, they will want to try it so they can join the conversation and share their opinions.

Burger King's Satisfries were also a big hit last year. But McDonald's Mighty Wings failed, primarily due to them being too expensive, too greasy, and facing too much competition in the wings space.

McDonald's did manage to deliver third-quarter comps growth of 0.7%, but that was nothing compared to Wendy's, which delivered 3.2% comps growth at company-owned locations and 3.1% comps growth at franchise locations. It should also be pointed out that Wendy's has sold many of its locations to franchisees, which streamlined profits. In the third quarter, adjusted earnings per share came in at $0.08 versus $0.02 in the year-ago quarter.

But is Wendy's likely to be the best investment option of the three going forward?

Wendy's vs. McDonald'sMcDonald's might have failed with its Mighty Wings, but it's going to learn from its mistakes. More importantly, it's going to keep track of what is successful at Burger King and Wendy's and then build on those concepts by bettering them. For example, don't be surprised if McDonald's comes out with a healthier version of its French fries at some point over the next few years. Whether it's French fries, a pretzel burger, or a menu item that has yet to be created, McDonald's has the most marketing power of the three franchises. Therefore, any successful innovations will likely lead to market-share gains and sales increases.

Furthermore, McDonald's is trading at just 16 times forward earnings, whereas Wendy's and Burger King are trading at 29 and 24 times forward earnings, respectively. Additionally, McDonald's yields 3.4%, versus 2.3% for Wendy's and 1.2% for Burger King.

The bottom lineThis isn't to say Wendy's and Burger King are poor investment options. They offer more growth potential than McDonald's. But McDonald's brand strength gives it a clear long-term advantage. If you're looking for growth, then consider that Wendy's overtook Burger King as the No. 2 hamburger chain in 2012 in regards to sales.

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